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Incorporation Separating Fact From Fiction

Written by: Steven J. Weil, PhD, EA

Article Overview: One of the most common questions I receive is should I Incorporate and will it mean I can deduct more on my tax return. The question comes up when I teach classes for small business owners and prospective new business owners. It also comes up at in email and phone calls I receive from clients and prospective clients on a regular basis. Many of those asking the question start with "I heard that if I incorporate I can deduct all my expenses and I will pay less in taxes". Although there are many reasons for Incorporating a business it's always important to do it for the right reasons and to understand the real costs, benefits and drawbacks. To do this it's important to start out by separating fact from fiction.

Incorporation Separating Fact From Fiction

Incorporation Separating Fact From Fiction

One of the most common questions I receive is should I Incorporate and will it mean I can deduct more on my tax return. The question comes up when I teach classes for small business owners and prospective new business owners. It also comes up at in email and phone calls I receive from clients and prospective clients on a regular basis.

Many of those asking the question start with "I heard that if I incorporate I can deduct all my expenses and I will pay less in taxes".

Although there are many reasons for Incorporating a business it's always important to do it for the right reasons and to understand the real costs, benefits and drawbacks. To do this it's important to start out by separating fact from fiction.

Fiction has it that the act of incorporating a business magically makes expenses that were not tax deductible, tax deductible.   This just is not true.

Fact for expenses to be deductable as a business expense, it must be customary and necessary and ordinary and necessary to the profit making activity of the business. This rule hold true whether your business is incorporated or not, so it makes no difference if you are incorporated or not.

Fiction incorporation can avoid state income taxes.  Business owners living in high tax states often believe that by incorporating in lower cost states they can avoid state taxes. This only works if the business is located in the lower tax state. 

Fact corporations are liable for tax not only in the state they incorporate but also in the states they have business operations. For example if a Nevada corporation does 100% of its business in California it will be subject to California tax on 100% of its income and profits.  For business that do business in more than one state or are virtual (internet based) incorporating in a low tax state may be useful so that only income and profits generated in the higher tax state are taxed by that state.

Fiction incorporation can shelter income from taxes on the owner's personal return. While this is true if the corporation earns a profit but does not pay it out to the share holders, the shareholders will not be subject to income tax on these profits until they are paid out. The corporation does have to pay tax on these profits at the corporate income tax rate which may be higher than the taxes the owner would have paid personally on these profits.

Fact dividends paid by regular C corporation are taxed at a maximum rate of 15% on individual tax returns as long as certain ownership time constants are met and the profits are from business operations not rental activities or interest received.  It should be noted for the lower tax rates on dividends to apply the corporation must have been a regular C corporation subject to corporate income tax at the corporate level.

Fact corporations and their share holders can elect to be taxed under sub chapter S of the internal revenue service code. Subchapter S corporations do not pay federal income tax on their profits, their profits and or losses are passed through to the shareholders and must be reported on the returns of the shareholders in the year in which the corporation's earnings or losses occurred. Shareholders must pay tax on profits earned by an S corporation in which they own stock regardless of whether or not they received the profits. They may also deduct losses sustained by the corporation subject to rules requiring participation and basis (capital at risk).

Fiction incorporation protects me from the claims of all creditors of my business. In most cases if you want credit or financing for your business you will be required to sign a personal guarantee, so you will still be on the hook for many business debits.

Fact incorporation can protect your personal assets from lawsuits generated by defective products, the acts of your employees (such as an employee hitting someone with their car while making a delivery) and breach of contract. But the liability protection only works if you treat your corporation properly and do not mix personal and business transactions. Keep your corporation's business checking account separate from your personal account, be sure to pay only corporate business expenses from the corporation's checking account and make sure you do not pay personal items through the corporate account. It also important not to sign anything or tell people you are the owner. Remember that when you sign or act for the corporation you are acting as an officer not as the owner or as a stockholder. Understanding corporate governance is important when you are operating a corporation.

Fiction Incorporation means I can eliminate paying social security self employment taxes. While incorporating your business will mean you no longer have to file schedule SE with your personal tax return and pay self employment tax on your business income, you are not totally off the hook. Corporate officers need to receive payroll from the corporation and payroll requires the withholding of income, Social Security and Medicare taxes. It also requires your corporation to match the Social Security and Medicare taxes it withholds from your payroll. In addition to Social Security and Medicare taxes your corporation will also be responsible for federal and state unemployment taxes. Some states also require employers to pay for other state funded programs so it's important to know what employment taxes your state requires.

Fact in many situations payroll taxes can be reduced by carefully allocating how much compensation will be received as payroll and how much profit will be allowed to pass through your corporation as profit and be paid out as dividends for regular corporations or as distributions for corporations that have elected to be taxes under sub chapter S of the Internal Revenue Service code.

Fiction there are no additional costs of being incorporated and no additional responsibilities.

Fact incorporating creates additional costs and responsibilities. These costs and responsibilities include the filing of separate federal and state corporate tax returns, maintaining a separate bank account for the corporation and payment of annual state filing fees. Corporations also require a higher level of record keeping then sole proprietorships.

There are many good reasons to incorporate, but when making this or any other business decision it's important to separate the facts for the fiction. Consulting a qualified tax professional can help you get a handle on how incorporating will affect you and your business.

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Article Tags: business expense, business operations, california tax, corporations, email, incorporating a business, incorporation, nevada corporation, new business, phone calls, profits, prospective clients, separating fact from fiction, small business owners, state income taxes, state taxes, tax return, tax states, virtual internet



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